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The Heavy Construction Industry: Investing Essentials

An investor's overview of the vital heavy construction industry.

Surely there are few industries responsible for activities as seemingly mundane as highway construction yet also projects as ambitious and esoteric as this:

TOKAMAK Reactor Foundation. Source: ITER Organization.

The image above is a photograph of the foundation for a specialized "tokamak" nuclear reactor for the International Thermonuclear Experimental Reactor, or ITER, Project. Located north of Aix-en-Provence, France, ITER will seek to capture the long-chased dream of nuclear fusion, through a $17 billion project funded by the European Union, the U.S., China, Japan, India, South Korea, and Russia. Before the scientists can begin their experimentation, the world's largest nuclear reactor will have to be built, and the heavy construction industry will play a significant role in completing this project.

What is the heavy construction industry?

The heavy construction industry is comprised of companies engaged in large-scale building projects, chiefly in infrastructure. A wide variety of corporations provide the planning, design, engineering, consulting, and construction expertise to complete such initiatives. Examples of construction projects include highways, ports, dams, cable and wireless networks, bridges, tunnels, water and sewer facilities, hydroelectric energy plants, railroads, and subways.

Companies in the industry are also engaged in infrastructure repair and maintenance, as well as specialized projects such as the building and decommissioning of nuclear plants.

How big is the heavy construction industry?

According to a 2014 report by PriceWaterhouseCoopers, spending on global infrastructure will grow from $4 trillion annually in 2012 to $9 trillion by 2025, with total spending during that period expected to reach $78 trillion. PWC's estimates include direct construction activities, as well as peripheral expenditures on logistics, legal fees, feasibility studies, etc. Bloomberg.com's "Industry Leaderboard" estimates revenue of companies directly involved in this industry at nearly $1.5 trillion annually.

As you might discern from these impressive numbers, the heavy construction industry is a sizable employer. The U.S. Bureau of Labor Statistics reports that total U.S. employees in the "Heavy and Civil Engineering" subsector of the construction industry number over 918,000.

Significant companies in this industry can rack up annual revenues in the tens of billions. For example, Fluor Corp. generated $27.4 billion in revenue in 2013. Privately held U.S. firm Bechtel, one of the world's leading civil engineering companies, disclosed 2012 revenues of $38 billion. China Railway Construction Corporation added an eyebrow-raising $95 billion to its top line in 2013.

How does the heavy construction industry work?

Eurostar trains at the renovated St. Pancras Station, London. U.S.-based Bechtel Corporation built the underground leg of the Channel Tunnel, or "Chunnel," between Britain and France, at a project cost of $14.7 billion. Source: Purple under Creative Commons License.

Because of the size of typical projects, the industry exhibits several unique characteristics. The clients of heavy construction and engineering firms tend to be federal and state governments, cities, and municipalities. Procurement, the process by which such organizations bid out and award projects, can be exceedingly complex (and competitive) at this scale. Profits are realized in some cases over a span of years, and final profit margins can be slim, averaging just 2.5%.

To a greater degree than in related industries (e.g., residential construction), work proposals require extensive estimates. Proposals based on a company's best guess as to costs of labor, materials, and subcontractors often get submitted years in advance of performance and are typically signed as "fixed-price contracts."

As a result, long-term revenue and profit in this industry involve inherent uncertainty. For example, when discussing the risk of cost overruns in its 2013 annual report, Fluor Corp. stated that approximately 20% of its backlog value was tied to fixed-price contracts. Needless to say, successful companies develop fairly precise pricing and economic models to provide a margin of safety in project proposals.

What are the drivers of the heavy construction industry?

One can track any number of industries in which global economic growth tangibly drives success. This is not quite the case with the heavy construction industry, as counterintuitive as it may seem. Because so much of this industry is fueled by national and local governments' spending, policy and political decisions can trump other critical success factors.

It generally holds that at the peak of an economic expansion cycle, heavy construction companies win the contracts that carry them through the rest of the cycle. But governments don't always spend in sync with the availability of resources.

For example, during the financial crisis and recession of 2008, eurozone governments made a critical decision to embark on a plan of austerity, and consequently shelved major infrastructure projects.

While the U.S. employed a stimulus approach to the financial crisis, funding for repair of the nation's deteriorating infrastructure was and continues to be modest because of disagreements in Congress over scope and funding. Unsurprisingly, the domestic industry has grown at a meager clip over the last several years.

Objective data would seem to point to the benefits of infrastructure improvement. A 2014 study by Standard & Poor's determined that every $1.3 billion invested in U.S. infrastructure would result in a net gain of 29,000 construction jobs, an addition of $2.0 billion of growth to the economy, and a reduction of $200 million in the federal deficit. Yet such arguments have so far had little impact on policy makers.

Consequently, Asia is projected to lead the world in infrastructure spending for several years. The crimped budgets in the U.S. and Europe (which together account for a majority of global infrastructure spending) will potentially drag on the revenue growth that construction companies extract from Asia and other emerging markets. Thus, investors should pay attention to the geographic distribution of a company's revenue when evaluating potential portfolio holdings in this industry.